Integrated Simulation and Optimization Models for Tracking Indices of Fixed-Income Securities

Increasing performance pressures on fixed-income managers have led to a search for new and creative ways to add to portfolio returns. The largest pension plan sponsors, insurance companies, foundations, and money management firms are using indexed portfolios as their fixed-income assets management strategies since the late 1970s. Tracking a fixed-income index is a difficult task due to transaction costs, portfolio size and diversification restrictions, liquidity requirements, bid/ask spreads, etc. This paper develops an integrated simulation and optimization approach for tracking fixed-income indices. The model was implemented at Metropolitan Life Insurance Company. We introduce a simulation model for generating scenarios of holding period returns of the securities in the index. Then we develop optimization models to select a portfolio that tracks the index. The models penalize downside deviations of the portfolio return from the index. The developed framework is used to track the Salomon Brothers Mortgage Index . In backtesting over the period 1989–1991, the models outperformed the index by 50bp. Underperformance never exceeded more than −5bp in any single month. A small tracking error was also observed during the recent months that the model has been in use.